Tag Archives: financial crises

The Coming Debt Crisis

After the 2008-09 global financial crisis, economists were criticized for not predicting its coming. This charge was not totally justified, as there were some who were concerned about the run-up in asset prices. Robert Schiller of Yale, for example, had warned that housing prices had escalated to unsustainable levels. But the looming debt crisis in the emerging market economies has been foreseen by many, although the particular trigger—a pandemic—was not.

Last year the World Bank released Global Waves of Debt: Causes and Consequences, written by M. Ayhan Kose, Peter Nagle, Franziska Ohnsorge and Naotaka Sugawara. The authors examined a wave of debt buildup that began in 2010. By 2018 total debt in the emerging markets and developing economies (EMDE) had risen by 54 percentage points to 168% of GDP. Much of this increase reflected a rise in corporate debt in China, but even excluding China debt reached a near-record level of 107% of GDP in the remaining countries.

The book’s authors compare the recent rise in the EMDE’s debt to other waves of debt accumulation during the last fifty years. These include the debt issued by governments in the 1970s and 1980s, particularly in Latin America; a second wave from 1990 until the early 2000s that reflected borrowing by banks and firms in East Asia and governments in Europe and Central Asia; and a third run-up in private borrowing via bank loans in Europe and Central Asia in the early 2000s. All these previous waves ended in some form of crisis that adversely affected economic growth.

While the most recent increase in debt shares some features with the previous waves such as low global interest rates, the report’s authors state that it has been “…larger, faster, and more broad-based than in the three previous waves…” The sources of credit shifted away from global banks to the capital markets and regional banks. The buildup included a rise in government debt, particularly among commodity-exporting countries, as well as private debt. China’s private debt rise accounted for about four-fifths of the increase in private EMDE debt during this period. External debt rose, particularly in the EMDEs excluding China, and much of these liabilities were denominated in foreign currency.

The World Bank’s economists report that about half of all episodes of rapid debt accumulation in the EMDEs have been associated with financial crises. They (with Wee Chian Koh) further explore this subject in a recent World Bank Policy Research Paper, “Debt and Financial Crises.” They identify 256 episodes of rapid government debt accumulation and 263 episodes of rapid private debt accumulation in 100 EMDEs over the period of 1970-2018. They test their effect upon the occurrence of bank, sovereign debt and currency crises in an econometric model, and find that such accumulations do increase the likelihood of such crises. An increase of government debt of 30 percentage points of GDP raised the probability of a debt crisis to 2% from 1.4% in the absence of such a build-up, and of a currency crisis to 6.6% from 4.1%. Similarly, a 15% of GDP rise in private debt doubled the probability of a bank crisis to 4.8% if there were no accumulation, and of a currency crisis to 7.5% from 3.9%. (For earlier analyses of the impact of external debt on the occurrence of bank crises see here and here.)

Kristin J. Forbes of MIT and Francis E. Warnock of the University of Virginia’s Darden Business School looked at episodes of extreme capital flows in the period since the global financial crisis (GFC) in a recent NBER Working Paper, “Capital Flows Waves—or Ripples? Extreme Capital Flow Movements Since the Crisis.”  They update the results reported in their 2012 Journal of International Economics paper, in which they distinguished between surges, stops, flights and retrenchments. They reported that before the GFC global risk, global growth and regional contagion were associated with extreme capital flow episodes, while domestic factors were less important.

Forbes and Warnock update their data base in the new paper. They report that has been a lower incidence of extreme capital flow episodes since 2009 in their sample of 58 advanced and emerging market economies, and such episodes occur more as “ripples” than “waves.” They also find that as in the past the majority of episodes of extreme capital flows were debt-led. When they distinguish between bank versus portfolio debt, their results suggest a substantially larger role for bank flows in driving extreme capital flows.

Forbes and Warnock also repeat their earlier analysis of the determinants of extreme capital flows using data from the post-crisis period. They find less evidence of significant relationships of the global variables with the extreme capital flows. Global risk is significant only in the stop and retrenchment episodes, and contagion is significantly associated only with surges. They suggest that these results may reflect changes in the post-crisis global financial system, such as greater use of unconventional tools of monetary policy, as well as increased volatility in commodity prices.

Corporations can respond to crises by changing how and where they raise funds. Juan J. Cortina, Tatiana Didier and Sergio L. Schmukler of the World Bank analyze these responses in another World Bank Policy Research Working paper, “Global Corporate Debt During Crises: Implications of Switching Borrowing across Markets.” They point out that firms can obtain funds either via bank syndicated lending or bonds, and they can borrow in international or domestic markets. They use data on 56,826 firms in advanced and emerging market economies with 183,732 issuances during the period 1991-2014, and focus on borrowing during the GFC and domestic banking crises. They point out that the total amounts of bonds and syndicated loans issued during this period increased almost 27-fold in the emerging market economies versus more than 7 times in the advanced economies.

Cortina, Didier and Schmukler found that the issuance of bonds relative to syndicated loans increased during the GFC by 9 percentage points from a baseline of 52% in the emerging markets, and by 6 percentage points in the advanced economies from a baseline probability of 28%. There was also an increase in the use of domestic debt markets relative to international ones during the GFC, particularly by emerging economy firms. During domestic banking crises, on the other hand, firms turned to the use of bonds in the international markets. When the authors used firm-level data, they found that this switching was done by larger firms.

The authors also report that the debt instruments have different characteristics. For example, the emerging market firms obtained smaller amounts of funds with bonds as compared to bank syndicated loans. Moreover, the debt of firms in emerging markets in international markets was more likely to be denominated in foreign currency, as opposed to the use of domestic currency in domestic markets.

Cortina, Didier and Schmukler also investigated how these characteristics changed during the GFC and domestic bank crises. While the volume of bond financing increased during the GFC relative to the pre-crisis years, syndicated bank loan financing fell, and these amounts in the emerging market economies fully compensated each other. In the advanced economies, on the other hand, total debt financing fell.

The global pandemic is disrupting all financial markets and institutions. The situation of banks in the advanced economies is stronger than it was during the GFC (but this could change), and the Federal Reserve is supporting the flow of credit. But the emerging markets corporations and governments that face falling exports, currency depreciations and enormous health expenditures will find it difficult to service their debt. Kristalina Georgieva, managing director of the IMF, has announced that the Fund will come to the assistance of these economies, and next week’s meeting of the IMF will address their needs. The fact that alarm bells about debt in emerging markets had been sounding will be of little comfort to those who have to deal with the collapse in financial flows.

Capital Controls in Theory and Practice

It has been a decade since the global financial crisis effectively ended opposition to the use of capital controls. The IMF’s drive towards capital account deregulation had been blunted by the Asian financial crisis of 1997-98, but there was still a belief in some quarters that complete capital mobility was an appropriate long-run goal for emerging markets once their financial markets sufficiently matured. The meltdown in financial markets in advanced economies in 2008-09 ended that aspiration. Several recent papers have summarized subsequent research on the justification for capital controls and the evidence on their effectiveness.

Bilge Erten of Northeastern University, Anton Korinek of the University of Virginia and José Antonio Ocampo of Columbia University have a paper, “Capital Controls: Theory and Evidence,” that was prepared for the Journal of Economic Literature and summarizes recent work on this topic. In this literature, the micro-foundations for the use of capital controls to improve welfare are based on externalities that private agents do not internalize. The first type of externality is pecuniary, which can lead to a change in the value of collateral and a redistribution between agents. In such cases, private agents may borrow more than is optimal for society, which suffers the consequences in the event of a financial shock. Policymakers can restrict capital flows to limit financial fragility.

The second justification of capital controls is due to aggregate demand externalities, which are associated with unemployment. Private agents may borrow in international markets and fuel a domestic boom that leaves the domestic economy vulnerable to a downturn. If there are domestic frictions and constraints on the use of monetary policy that limit the response to an economic contraction, then capital controls may be useful in mitigating the downturn.

Alessandro Rebucci of Johns Hopkins and Chang Ma of Fudan University also summarize this literature in “Capital Controls: A Survey of the New Literature,” prepared for the Oxford Research Encyclopedia of Economics and Finance. They discuss the use capital controls in the case of both pecuniary and demand externalities, and capital controls in the context of the trilemma. In their review of the empirical literature on capital controls, they summarize two lines of research. The first deals with the actual use of capital controls, and the second their relative effectiveness.

Whether or not capital controls are used as a countercyclical instrument together with other macroprudential tools has been an issue of dispute.  Rebucci and Ma report there is recent evidence that indicates that such instruments have been utilized in this manner, as the recent theoretical literature proposes. There are also cross-country studies of capital control effectiveness that are consistent with the theoretical justification for the use of such measures. For example, capital controls can limit financial vulnerability by shifting the composition of a country’s external balance sheet away from debt.

Some recent papers from the IMF investigate the actual use of capital controls and other policy tools in emerging market economies. Atish R. Ghosh, Jonathan D. Ostry and Mahvash S. Qureshi of the IMF investigated the response of emerging markets to capital flows in a 2017 working paper, “Managing the Tide: How Do Emerging Markets Respond to Capital Flows?” They report that policymakers in a sample of 51 countries over the period of 2005-13 used a number of instruments to deal with capital flows. In addition to foreign exchange market intervention and central bank policy rates, capital controls were utilized, particularly when the inflows took the form of portfolio and other flows. Tightening of capital inflow controls was more likely during periods of credit growth and real exchange rate appreciation. The authors’ finding that several major emerging markets have used capital controls to deal with risks to financial and macroeconomic stability is consistent with the theoretical literature cited above. However, the authors caution that their results do not indicate whether managing capital flows actually prevents or dampens instability.

This subject has been addressed by Gaston Gelos, Lucyna Gornicka, Robin Koepke, Ratna Sahay and Silvia Sgherri  in their new IMF working paper, “Capital Flows at Risk: Taming the Ebbs and Flows.” They examine the policy responses to sharp portfolio flow movements in 35 emerging market and developing economies during the 1996-2018 period, using a rise in BBB-rated U.S. corporate bond yields as a global shock. The authors look at the structural characteristics and policy frameworks of the countries as well as their policy actions. Among their results they find that more open capital accounts at the time of the shock are associated with fewer large inflows after the shock. Moreover, a tightening of capital flow measures is linked to larger outflows in the short-run. They also find that monetary and macroprudential policies have limited effectiveness in shielding countries from the risks associated with global shocks.

Capital controls have become an important tool for many developing economies, and there are ample grounds to justify their implementation. Recent empirical literature seems to show that the actual implementation of such measures is undertaken in a manner that meets the criteria outlined in the theoretical literature. However, whether regulatory limits on capital mobility actually achieve their financial and macroeconomic goals is still not proven. The Federal Reserve has signaled its intention to maintain the Federal Funds Rate at its current level, but shocks can come from many sources. Policymakers may find themselves drawing upon all the tools available to them in the case of a new global disruption to capital flows.

Global Networks and Financial Instability

The ten-year anniversary of the global financial crisis has brought a range of analyses of the current stability of the financial system (see, for example, here). Most agree that the banking sector is more robust now due to increased capital, less leverage, more prudent balance sheets and better regulation. But systemic risk is an inherent feature of finance, and a disturbance in one area can quickly spread to others through global networks.

The growth of financial markets and institutions during the 1990s and 2000s benefitted many, including those in emerging market economies that became integrated with world markets during this period. But the large-scale extension of credit to the housing sector led to property bubbles in the U.S., as well as in Ireland and Spain. The development of financial instruments such as mortgage backed securities (MBS), collateralized debt obligations (CDOs), and credit default swaps (CDS) were supposed to spread the risk of lenders in order to mitigate the impact of a negative price shock. However, these instruments and the extension of credit to subprime borrowers increased the vulnerability of financial institutions to reversals in the housing markets. Risk increased in a non-linear fashion as balance sheets became highly leveraged, and national regulators simply did not understand the nature and scale of these risks.

The holdings of assets across borders amplified the impact of the disruption of the U.S. financial markets once housing prices fell. European banks that had borrowed dollars in order to participate in the U.S. MBS markets found themselves exposed when dollar funding was no longer available. The gross flows of money between the U.S. and Europe increased the ties between their institutions and increased the fragility of their financial markets. It took the the establishment of swap networks between the Federal Reserve and European central banks to provide the necessary dollar funding.

John Kay has written about the inability to recognize and minimize systemic risk in financial systems in Other People’s Money: The Real Business of Finance. He draws from engineers the lesson that “…stability and resilience requires conscious and systematic simplification, modularity, which enables failures to be contained, and redundancy, which allows failed elements to be by-passed. None of these features—simplification, modularity, redundancy—characterized the financial system as is had developed in 2008.”

Similarly, Ian Goldin of Oxford University and Chris Kutarna examined the impact of rising financial complexity on the stability of financial systems in the period leading up to the crisis: “Cumulative connective and developmental forces produced a global financial system that was suddenly far bigger and more complex than just a decade before. This made the new hazards harder to see and simultaneously spread the dangers more widely—to workers, pensioners, and companies worldwide.”

Goldin and Mike Marithasan of KU Leuven also looked at the impact of increasing complexity on financial systems in The Butterfly Defect: How Globalization Creates Systemic Risks, and What to Do About It. They use Iceland as an example of how complex financial relationships were constructed with virtually no understanding of the consequences if they unraveled. They draw several lessons for dealing with a more complex financial networks. These include global oversight by regulators using systemic analysis, and the use of simple rules such as leverage ratios rather than complex regulations.

The Basel III regulatory regime follows this advice in a number of areas. But the basic vulnerability of financial networks remains. Yevgeniya Korniyenko, Manasa Patnam, Rita Maria del Rio-Chanon and Mason A. Porter have analyzed the interconnectedness of the global financial system in an IMF working paper, “Evolution of the Global Financial Network and Contagion: A New Approach.” They use a multilayer network framework with data on foreign direct investment, portfolio equity and debt and bank loans over the period 2008-15 to analyze the global financial network.

The authors compare the networks for the years 2009 and 2015, and report which countries are systematically important in the networks. They find that the U.S. and the U.K. appear at the top of these rankings in both of the selected years, although the cross-border holdings of U.S. financial institutions has increased over time while those of the U.K.’s institutions fell. China has moved up in the rankings, as have other Asian countries such as Singapore and South Korea. The authors conclude that “The global financial network remains most susceptible to shocks coming from large central countries…and countries with large financial systems (namely, the USA and the UK)…”

A decade after the global crisis, the possibility of the rapid propagation of a financial shock remains. There is more resiliency in those parts of the financial system that failed in 2008, but the current most vulnerable areas may not be identified until there is a new crisis. Policymakers who ignore this reality will be tripped up when the next shock occurs, and they will learn that  “The past is not dead. It’s not even past.”

The 2018 Globie: “Crashed”

Each year I choose a book to be the Globalization Book of the Year, i.e., the “Globie”. The prize is strictly honorific and does not come with a check. But I do like to single out books that are particularly insightful about some aspect of globalization.  Previous winners are listed at the bottom.

This year’s choice is Crashed: How a Decade of Financial Crises Changed the World by Adam Tooze of Yale University. Tooze, an historian, traces the events leading up to the crisis and the subsequent ten years. He points out in the introduction that this account is different from one he may have written several years ago. At that time Barak Obama had won re-election in 2012 on the basis of a slow but steady recovery in the U.S. Europe was further behind, but the emerging markets were growing rapidly, due to the demand for their commodities from a steadily-growing China as well as capital inflows searching for higher returns than those available in the advanced economies.

But the economic recovery has brought new challenges, which have swept aside established politicians and parties. Obama was succeeded by Donald Trump, who promised to restore America to some form of past greatness. His policy agenda includes trade disputes with a broad range of countries, and he is particularly eager to impose trade tariffs on China. The current meltdown in stock prices follows a rise in interest rates normal at this stage of the business cycle but also is based on fears of the consequences of the trade measures.

Europe has its own discontents. In the United Kingdom, voters have approved leaving the European Union. The European Commission has expressed its disapproval of the Italian government’s fiscal plans. Several east European governments have voiced opposition to the governance norms of the West European nations. Angela Merkel’s decision to step down as head of her party leaves Europe without its most respected leader.

All these events are outcomes of the crisis, which Tooze emphasizes was a trans-Atlantic event. European banks had purchased held large amounts of U.S. mortgage-backed securities that they financed with borrowed dollars. When liquidity in the markets disappeared, the European banks faced the challenge of financing their obligations. Tooze explains how the Federal Reserve supported the European banks using swap lines with the European Central Bank and other central banks, as well as including the domestic subsidiaries of the foreign banks in their liquidity support operations in the U.S. As a result, Tooze claims:

“What happened in the fall of 2008 was not the relativization of the dollar, but the reverse, a dramatic reassertion of the pivotal role of America’s central bank. Far from withering away, the Fed’s response gave an entirely new dimension to the global dollar” (Tooze, p. 219)

The focused policies of U.S. policymakers stood in sharp contrast to those of their European counterparts. Ireland and Spain had to deal with their own banking crises following the collapse of their housing bubbles, and Portugal suffered from anemic growth. But Greece’s sovereign debt posed the largest challenge, and exposed the fault line in the Eurozone between those who believed that such crises required a national response and those who looked for a broader European resolution. As a result, Greece lurched from one lending program to another. The IMF was treated as a junior partner by the European governments that sought to evade facing the consequences of Greek insolvency, and the Fund’s reputation suffered new blows due to its involvement with the various rescue operations.The ECB only demonstrated a firm commitment to its stabilizing role in July 2012, when its President Mario Draghi announced that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro.”

China followed another route. The government there engaged in a surge of stimulus spending combined with expansionary monetary policies. The result was continued growth that allowed the Chinese government to demonstrate its leadership capabilities at a time when the U.S. was abandoning its obligations. But the ensuing credit boom was accompanied by a rise in private (mainly corporate) lending that has left China with a total debt to GDP ratio of over 250%, a level usually followed by some form of financial collapse. Chinese officials are well aware of the domestic challenge they face at the same time as their dispute with the U.S. intensifies.

Tooze demonstrates that the crisis has let loose a range of responses that continue to play out. He ends the book by pointing to a similarity of recent events and those of 1914. He raises several questions: “How does a great moderation end? How do huge risks build up that are little understood and barely controllable? How do great tectonic shifts in the global world order unload in sudden earthquakes?” Ten years after a truly global crisis, we are still seeking answers to these questions.

Previous Globie Winners:

2017    Stephen D. King, Grave New World: The End of Globalization, the Return of History

2016    Branko Milanovic, Global Inequality

2015    Benjamin J. Cohen. Currency Power: Understanding Monetary Rivalry

2014    Martin Wolf, The Shifts and the Shocks: What We’ve Learned–and Have Still to Learn–from the Financial Crisis

 

The Spillover Effects of Rising U.S. Interest Rates

U.S. interest rates have been rising, and most likely will continue to do so. The target level of the Federal Funds rate, currently at 1.75%, is expected to be raised at the June meeting of the Federal Open Market Committee. The yield on 10-year U.S. Treasury bonds rose above 3%, then fell as fears of Italy breaking out the Eurozone flared. That decline is likely to be reversed while the new government enjoys a (very brief) honeymoon period. What are the effects on foreign economies of the higher rates in the U.S.?

One channel of transmission will be through higher interest rates abroad. Several papers from economists at the Bank for International Settlements have documented this phenomenon. For example, Előd Takáts and Abraham Vela of the Bank for International Settlements in a 2014 BIS Paper investigated the effect of a rise in the Federal Funds rate on foreign policy rates in 20 emerging market countries, and found evidence of a significant impact on the foreign rates. They did a similar analysis for 5-year rates and found comparable results. Boris Hofmann and Takáts also undertook an analysis of interest rate linkages with U.S. rates in 30 emerging market and small advanced economies, and again found that the U.S. rates affected the corresponding rates in the foreign economies. Finally, Peter Hördahl, Jhuvesh Sobrun and Philip Turner attribute the declines in long-term rates after the global financial crisis to the fall in the term premium in the ten-year U.S. Treasury rate.

The spillover effects of higher interest rates in the U.S., however, extend beyond higher foreign rates. In a new paper, Matteo Iacoviello and Gaston Navarro of the Federal Reserve Board investigate the impact of higher U.S. interest rates on the economies of 50 advanced and emerging market economies. They report that monetary tightening in the U.S. leads to a decline in foreign GDP, with a larger decline found in the emerging market economies in the sample. When they investigate the channels of transmission, they differentiate among an exchange rate channel, where the impact depends on whether or not a country pegs to the dollar; a trade channel, based on the U.S. demand for foreign goods; and a financial channel that reflects the linkage of U.S. rates with the prices of foreign assets and liabilities. They find that the exchange rate and trade channels are very important for the advanced economies, whereas the financial channel is significant for the emerging market countries.

Robin Koepke, formerly of the Institute of International Finance and now at the IMF, has examined the role of U.S. monetary policy tightening in precipitating financial crises in the emerging market countries. His results indicated that there are three factors that raise the probability of a crisis: first, the Federal Funds rate is above its natural level; second, the rate increase takes place during a policy tightening cycle; and third, the tightening is faster than expected by market participants. The strongest effects were found for currency crises, followed by banking crises.

According to the trilemma, policymakers should have options that allow them to regain monetary control. Flexible exchange rates can act as a buffer against external shocks. But foreign policymakers may resist the depreciation of the domestic currency that follows a rise in U.S. interest rates. The resulting increase in import prices can trigger higher inflation, particularly if wages are indexed. This is not a concern in the current environment. But the depreciation also raises the domestic value of debt denominated in foreign currencies, and many firms in emerging markets took advantage of the previous low interest rate regime to issue such debt. Now the combination of higher refinancing costs and exchange rate depreciation is making that debt much less attractive, and some central banks are raising their own rates to slow the deprecation (see, for example, here and here and here).

Dani Rodrik of the Kennedy School and Arvin Subramanian, currently Chief Economic Advisor to the Government of India, however, have little sympathy for policymakers who complain about the actions of the Federal Reserve. As they point out, “Many large emerging-market countries have consciously and enthusiastically embraced financial globalization…there were no domestic compulsions forcing these countries to so ardently woo foreign capital.” They go on to cite the example of China, which “…has chosen to insulate itself from foreign capital and has correspondingly been less affected by the vagaries of Fed actions…”

It may be difficult for a small economy to wall itself off from capital flows. Growing businesses will seek new sources of finance, and domestic residents will want to diversify their portfolios with foreign assets. The dollar has a predominant role in the global financial system, and it would be difficult to escape the spillover effects of its policies. But those who lend or borrow in foreign markets should realize, as one famed former student of the London School of Economics warned, that they play with fire.

After the Global Financial Crisis: Are We Safe Now?

A decade after the global financial crisis the global economy seems (finally) to be enjoying a robust recovery. Economic growth is widespread and includes increased expenditures on investment, a sign that business firms expect continuing demand for their products. With the crisis finally behind us, we can revisit it to reassess its causes and the response. We can also ask whether our ability to respond to another crisis is adequate.

Reappraisals of the roots of the crisis have focused on the fragility of the financial sector, and the consequences of inadequate capital and liquidity shortfalls. Low interest rates due in part to foreign savings contributed to a rise in housing prices in the U.S., and the extension of mortgage loans to borrowers who sought to profit from further price increases. Bankers were willing to extend credit in part because they could pass along any risk through the sale of mortgage-backed securities, in some cases to financial firms in Europe. Credit booms in the housing sector also occurred in other countries, most notably Ireland and Spain.

But by 2007 as interest rates and the price of servicing the debt rose, housing prices stalled and mortgage borrowers who expected capital gains began to exit the market. The mortgage-backed securities lost their value, which led to a chain of liquidations of positions that pushed their prices further down. In the summer of 2008 the federal government was forced to take over the government-sponsored agencies, the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), that were active in the secondary market for mortgage securities. The failure of Lehman Brothers in September 2008 signaled a financial collapse that quickly spread to Europe.

In the aftermath of the crisis there was a wave of new rules in the financial sector. National bank regulators acting together at the Basel Committee on Banking Supervision revised capital adequacy ratios. In the U.S. the Dodd–Frank Wall Street Reform and Consumer Protection Act was enacted to overhaul and update our regulatory rules and institutions. The bill consolidated government supervisory agencies, extended their reach and introduced new tools, including a mechanism to allow the orderly closure of financial companies that have failed. The Consumer Financial Protection Bureau (CFPB) was established to prevent the predatory mortgage and other lending practices that had contributed to the crisis.

While national leaders were criticized at the time for an initially fumbling response, Daniel Drezner of the Fletcher School at Tufts University appraised the macroeconomic and financial policies undertaken at the time of the crisis and concluded that the system “worked,” i.e., the policy measures undertaken adverted a much worse outcome. The leaders of the Group of 20 nations (the successor to the Group of 7) agreed to increase government spending and to expand the resources of the International Monetary Fund to allow it to lend to a range of countries. Just as importantly, they also agreed to refrain from implementing trade barriers or engaging in competitive exchange rate depreciations. The Federal Reserve, aware of the central role of the dollar, instituted swap agreements with foreign central banks that enabled them to assist their banks with dollar obligations.

Ten years later, is the global economy safe from another financial meltdown? If one did occur, could we respond as aggressively? Because of the slow recovery, credit growth does not seem excessive—with the significant exception of China. Global stock markets, on the other hand, continue to set new records. The U.S. cyclically adjusted price earnings ratio has reached a level only seen in 1929 and during the “tech bubble,” leading inevitably to explanations of why this time the valuation is justified. Bitcoin, supposedly a new form of currency, continues to draw investors with a scarce understanding of what they are purchasing, and many are doing so by borrowing on their credit cards. A collapse in prices could lead to an unraveling of positions and a new round of liquidations that could extend into other financial markets.

Unfortunately, central banks will have limited room to respond. While the Federal Reserve is increasing the Federal Funds rate, it currently stands at only 1.50%. But even this is higher than the Bank of England’s target rate of 0.5% or the European Central Bank’s 0.0%. Central banks could return to quantitative easing operations but they would be beginning with much larger balance sheets than they had in 2008. A fiscal stimulus would be effective in the event of an economic contraction, but the U.S. has just enacted tax cuts that are expected to add $1.5 trillion to the federal debt. How would financial markets respond if a new downturn lowered tax revenues further as the government sought to increase spending?

Moreover, the financial sector in advanced economies is just as large as it was before the crisis. The size of financial sectors has been cited as a cause of concern by economists at the Bank for International Settlements and also a team at the IMF. The latter paper finds: “The effects of financial development on growth and stability show that there are tradeoffs, since at some point the costs outweigh the benefits.” There seems little doubt that we reached that point years ago.

There also seems to be no recognition of the fragility of the financial sector, and the threat it can pose. The success of governments in preventing a recurrence of the Great Depression precluded a public accounting of the causes of the crisis and the dangers of financial excess. A recent column in The Economist concluded:

“The success of the response to the downturn helped avoid some of the disasters of the 1930s. But it also left the fundamentals of the system that produced the crisis unchanged. Ten years on, the hopes of radical reform are all but dashed. The sad upshot is that the global economy may have the opportunity to relearn the lessons of the past rather sooner than hoped.”

If such a disaster occurs, it is difficult to imagine how the current administration in the U.S. would respond. There is no sense of common purpose or even an acknowledgement of the global interdependence of economies. Economic nationalism during a period of volatility will surely set off a round of tit-for-tat responses that in the end would leave no country better off.

In the meantime the financial sector enjoys continuing growth in earnings and the U.S. Congress is preparing to loosen some of the Dodd-Frank banking restrictions. But, as Martin Wolf of the Financial Times has warned, “The world at the beginning of 2018 presents a contrast between its depressing politics and its improving economics.” Markets can and do change rapidly,and there are many potential sources of disruption. And the greatest danger is always the one you do not see coming.

Venezuela and the Next Debt Crisis

The markets for the bonds of emerging markets have been rattled by developments in Venezuela. On November 13,Standard & Poor’s declared Venezuela to be in default after that country missed interest payments of $200 million on two government bonds. Venezuelan President Nicolás Maduro had pledged to restructure and refinance his country’s $60 billion debt, but there were no concrete proposals offered at a meeting with bondholders. By the end of the week, however, support from Russia and China had allowed the country to make the late payments.

Whether or not Venezuela’s situation can be resolved, the outlook for the sovereign debt of emerging markets and developing economies is worrisome. The incentive to purchase the debt is clear: their recent yields of about 5% and total returns of over 10% have surpassed the returns on similar debt in the advanced economies. The security of those returns seem to be based on strong fundamental condtions: the IMF in its most recent World Economic Outlook has forecast growth rates for emerging market and developing economies of 4.6% in 2017, 4.9% next year and 5% over the medium term.

The Quarterly Review of the Bank for International Settlements last September reviewed the government debt of 23 emerging markets, worth $11.7 trillion. The BIS economists found that much of this debt was denominated in the domestic currency, had maturities comparable to those of the advanced economies, and carried fixed rates. These trends, the BIS economists reported, “..should help strengthen public finance sustainability by reducing currency mismatches and rollover risks.”

It was not surprising, then when earlier this year the Institute for International Finance announced that total debt in developing countries had risen by $3 trillion in the first quarter. But surging markets invariably attract borrowers with less promising prospects. A FT article reported more recent data from Dealogic, which tracks developments in these markets, that shows that governments with junk-bond ratings raised $75 billion in syndicated bonds this calendar year. These bonds represented 40% of the new debt issued in emerging markets. Examples of such debt include the $3 billion bond issue of Bahrain, Tajikistan’s $500 million issue and the $3 billion raised by Ukraine. These bonds offer even higher yields, in part to compensate bondholders for their relative illiquidity.

The prospects for many of these economies are not as promising as the IMF’s aggregate forecast indicates. The IMF’s analysis also pointed out that there is considerable variation in performance across the emerging market and developing economies. The projected high growth forecast for the next several years is based in large part on anticipated growth in India and China, which account for more than 40% of the collective GDP of these nations. Weaker growth is anticipated in Latin America and the Caribbean, sub-Saharan Africa, North Africa and the Middle East.

The IMF also raised concerns about the sustainability of the sovereign debt of these countries in October’s Global Financial Stability Report. In the case of low-income countries, the report’s authors warned: “…this borrowing has been accompanied by an underlying deterioration in debt burdens… Indeed, annual principal and interest repayments (as a percent of GDP or international reserves) have risen above levels observed in regular emerging market economy borrowers.” Similarly, Patrick Njoroge, head of Kenya’s central bank, has warned that some African nations have reached a debt-servicing threshold beyond which they should not borrow.

None of these developments will surprise anyone familiar with the Minsky-Kindleberger model of financial crises. This account of the dynamics of such crises begins with an initial change in the economic environment—called a “displacement”—that changes the outlook for some sector (or nation). The prospect of profitable returns attracts investors. Credit is channelled by banks to the new sector, and the increase in funds may be reinforced by capital inflows.The demand for financial assets increases their prices. There is a search for new investments as the original investors take profits from their initial positions while new investors, regretful at missing earlier opportunities, join the speculative surge. The pursuit of yield is met by the issuance of new, increasingly risky assets. The “speculative chase” further feeds a price bubble, which is always justified by claims of strong fundamentals.

At some point there is a reassessment of market conditions. This may be precipitated by a specific event, such as a leveling off of asset prices or a rise in the cost of funding. An initial wave of bankruptcies or defaults leads to the exit of some investors and price declines. Further selling and the revelation of the flimsy undergirding of the speculative bubble results in what Kindleberger calls “revulsion.” In a world of global financial flows there are “sudden stops” as foreign investors pull out their funds, putting pressure on fixed exchange rates. Contagion may carry the revulsion across national boundaries. The end, Kindleberger wrote, comes either when prices fall so low that investors are drawn back; or transactions are shut down; or when a lender of last resort convinces the market that sufficient liquidity will be provided.

The market for the bonds of developing economies has followed this script. The initial displacement was the improvement in the growth prospects of many emerging market countries at a time when the returns on fixed investments in the advanced economies were relatively low. A credible case could be made that emerging market economies had learned the lessons of the past and had structured their debt appropriately. But the subsequent increase in bond offerings by governments with below investment grade ratings shows that foreign investors in their eagerness to enter these markets were willing to overlook more risky circumstances. This leaves them and the governments that issued the bonds vulnerable to shocks in the global financial system. A rise in risk aversion or U.S. interest rates would lead to rapid reassessments of the safety and sustainability of much of this debt.

This potential crisis has caught the attention of those who would be responsible for dealing with its painful termination. The IMF’s Managing Director Christine Lagarde at the Fund’s recent annual fall meeting warned of the risk of “a tightening of the financial markets and the potential capital outflows from emerging market economies or from low‑income countries where there has been such a search for yield in the last few years.” The IMF has dealt with this type of calamity before, and it never ends well.

Trilemmas and Financial Instability

Whether or not the international monetary trilemma (the choice facing policymakers among monetary autonomy, capital mobility and a fixed exchange rate) allows policymakers the scope for policy autonomy has been the subject of a number of recent analyses (see here for a summary). Hélène Rey of the London Business School has claimed that the global financial cycle constrains the ability of policymakers to affect domestic conditions regardless of the exchange rate regime. Michael Klein of the Fletcher School at Tufts and Jay Shambaugh of George Washington University, on the other hand, have found that exchange rate flexibility does provide a degree of monetary autonomy. But is monetary policy sufficient to avoid financial instability if accompanied by unregulated capital flows ?

A recent paper by Maurice Obstfeld, Jonathan D. Ostry and Mahvash S. Qureshi of the IMF’s Research Department examines the impact of the trilemma in 40 emerging market countries over the period of 1986-2013. They report that the choice of exchange rate regime does affect the sensitivity of domestic financial variables, such as domestic credit, house prices and bank leverage, to global conditions. Economies with fixed exchange rate regimes are more impacted by changes in global market volatility than those with flexible exchange rate regimes. They also find that capital inflows are sensitive to the choice of exchange rate regime.

However, the insulation properties of flexible exchange rates are not sufficient to protect a country from financial instability. Maurice Obstfeld of the IMF and Alan M. Taylor of UC-Davis in a new paper point out that while floating rates and capital mobility allow policy makers to focus on domestic objectives, “…monetary policy alone may be a relatively ineffective tool for addressing potential financial stability problems….exposure to global financial shocks and cycles, perhaps the result of monetary or other developments in industrial-country financial markets, may overwhelm countries even when their exchange rates are flexible.”

Global capital flows can adversely affect a country through multiple channels. The Asian financial crisis of 1998 demonstrated the impact of sudden stops, when inflows of foreign capital turn to outflows. The withdrawal forces adjustments in the current account and disrupts domestic financial markets, and can trigger a devaluation of the exchange rate. The fall in the value of the currency worsens a country’s situation when there are liabilities denominated in foreign currencies, and this balance sheet effect can overwhelm the expansionary impact of the devaluation on the trade balance.

The global financial crisis of 2008-09 showed that gross inflows and outflows as well as net flows can lead to increased financial risk. Before the crisis there was a tremendous buildup of external assets and liabilities in the advanced economies. Once the crisis began, the volatility in their financial markets was reinforced as residents liquidated their foreign assets in response to their need for liquidity (see Obstfeld here or here).

International financial integration can also raise financial fragility before a crisis emerges. Capital flows can be highly procyclical, fluctuating in response to business cycles (see here and here). Many studies have shown that the inflows result in increases in domestic credit that foster more economic activity (see here for a summary of recent papers). Moritz Schularick of the Free University of Berlin and Alan Taylor of UC-Davis (2012)  have demonstrated that these credit booms can result in financial crises.

What can governments do to forestall international financial instability?  Dirk Schoenmaker of VU University Amsterdam and the Duisenberg School of Finance has offered another trilemma, the financial trilemma, that addresses this question (see also here). In this framework, a government can choose two of the following three financial objectives: national financial regulatory policies, international banking with international regulation, and/or financial stability. For example, financial stability can occur when national financial systems are isolated, such as occurred under the Bretton Woods system. Governments imposed barriers on capital integration and effectively controlled their financial systems, and Obstfeld and Taylor point out that the Bretton Woods era was relatively free of financial crises. But once countries began to remove capital controls and deregulated their financial sectors in the post-Bretton Woods era, financial crises reappeared.

International financial integration combined with regulatory cooperation could lessen the consequences of regulation-shopping by global financial institutions seeking the lowest burden. But while the Financial Stability Board and other forums may help regulators monitor cross-border financial activities and design crisis resolution schemes, such coordination may be necessary but not sufficient to avoid volatility. Macroprudential policies to minimize systemic risk in the financial markets are a relatively new phenomenon, and largely planned and implemented on the national level. The global implications are still to be worked out, as Stephen G. Cecchetti of the Brandeis International Business School and Paul M. W. Tucker of the Systemic Risk Council and a Fellow at Harvard’s Kennedy School of Government have shown. A truly stable global system requires a degree of financial regulation and coordination that current national governments are not willing to accept.

The IMF’s Flexible Credit Line

The policy conditions attached to the disbursement of an IMF loan have long been the subject of controversy. In the wake of the global financial crisis, the IMF introduced a new lending program—the Flexible Credit Line—that allowed its members to apply for a loan before a crisis took place. If approved, the member can elect to draw upon the arrangement in the event of a crisis without conditionality, and there is no cap to the amount of credit. However, only three countries—Colombia, Mexico and Poland—have signed up for the FCL, and the lack of response to an IMF program without conditions has been a bit of a mystery. A new paper, “The IMF and Precautionary Lending: An Empirical Evaluation of the Selectivity and Effectiveness of the Flexible Credit Line“ by Dennis Essers and Stefaan Ide of the National Bank of Belgium, provides evidence that helps to explain the muted response.

Essers and Ide deal with two aspects of the FCL: first, the factors that explain the decision to participate in the program, and second, the effectiveness of the program in boosting market confidence in its users. This paper is very well-done, both from the perspective of dealing with an important issue as well using appropriate econometric tools for the analysis, and it received a prize for best paper at the INFINITI conference in Valencia. The authors point out that the views expressed in the paper are theirs, and do not necessarily reflect the views of the National Bank of Belgium or any other institution to which they are affiliated.

The results in the first half of the paper can explain why so few countries have adopted the FCL. On the “demand side,” Colombia, Mexico, and Poland applied for the FCL because they were vulnerable to currency volatility as manifested by exchange market pressure. On the “supply side,” the IMF was willing to accept them into the program because 1—the economies were not showing signs of financial or economic instability, as manifested by lower bond interest rate spreads and inflation rates, and 2—they met the “political” criteria of high shares in U.S. exports and acceptable United Nations voting patterns.

If this line of reasoning is correct, then the adoption of the FCL will always be limited. The authors point out that the “…the influence of the first two variables (EMBI spread, inflation) is in line with supply-side arguments…” The qualifying criteria on the IMF web page that explains the program include:

  • “A track record of steady sovereign access to international capital markets at favorable terms”
  • “Low and stable inflation, in the context of a sound monetary and exchange rate policy framework”

However, lower bond spreads and inflation (and macroeconomic stability) can also be viewed as factors that lower the demand for IMF programs, as would most of the other criteria, i.e., a “sustainable external position,” “a capital position dominated by private flows,” “a reserve position which…remains relatively comfortable,” “a sustainable public debt position,” and “the absence of solvency problems.” My first paper on the economic characteristics of IMF program countries found that countries that entered IMF programs in the early 1980s had higher rates of domestic credit growth, larger shares of government expenditure, more severe current account deficits, and smaller reserve holdings. Therefore, the applicants for the FCL have been countries that do not have the features of those that apply for the standard IMF program, the Stand-By Arrangement, and yet decided to apply for the FCL because of some form of exchange market pressure.

Such a confluence of factors may be relatively rare. If the country is experiencing exchange market pressure, ordinarily we would expect to see increased bond spreads. Moreover, exchange market pressure could be a reaction to domestic macroeconomic instability, which could be linked to rising inflation rates. The three countries were experiencing some combination of exchange rate depreciation and/or a drain on their international reserves, but their bond rate spreads were not rising and domestic inflation was not a concern. In addition, the governments also met the IMF’s (hidden) political criteria.

If such a combination is unusual, then to enhance participation in the FCL, the IMF would have to be willing to relax its official criteria for selection. It would also need to deal with countries that have not always accommodated U.S. foreign policy. This may require some “bargaining” among the major shareholder countries at a time when international agreements and organizations are being looked on with suspicion. The time to promote the program, however, is now, while international financial markets are relatively calm. Unfortunately, there is always a tendency to project current conditions into the future, and to delay adopting precautionary measures. When circumstances force governments to turn to the Fund, they will not qualify for the no-conditions FCL, but for programs with much more stringent criteria.

Crises and Coordination

Policy coordination often receives the same type of response as St. Augustine gave chastity: “Lord, grant me chastity and continence, but not yet.” A new volume from the IMF, edited by Atish R. Ghosh and Mahvash S. Qureshi, includes the papers from a 2015 symposium devoted to this subject. Policymakers in an open economy who take each other’s actions into account should be able to reach higher levels of welfare than they would working in isolation.  But actually engaging in coordination turns out to be harder–and less common– than many may think.

Jeffrey Frankel of Harvard’s Kennedy School of Government uses game theory to illustrate the circumstances that hamper coordination. One factor may be a fundamental divergence in how different policymakers view a situation. Many analysts on this side of the Atlantic, for example, use the “locomotive game” to show that Germany should engage in expansionary fiscal policies that would raise output for all nations. But (most) German policymakers have different views of the external impact of deficit spending. In the case of the Eurozone, a deficit in one country increases the probability that it will need a bailout by the other members of the monetary union. Only rules such as those of the Stability and Growth Pact that limit deficit expenditures can eliminate the moral hazard that would otherwise lead to widespread defaults.

Charles Engel of the University of Wisconsin (working paper here) also examines the recent literature on central bank coordination. He points out that the identifying the source of shocks is necessary to assess the benefits of cooperation to address them, and suggests that financial sector shocks may be most relevant for modeling open-economy coordination. But widespread cooperation could undercut the ability of a central bank to credibly commit to a single target, such as an inflation target.

Policymakers in emerging markets who must deal with the consequences of policies in advanced economies have been particularly mindful of their spillover effects. Raghuram Rajan, for example, who is back at the University of Chicago after serving as head of India’s central bank, has urged the Federal Reserve and other central banks to take into account the impact that their policies have on other nations, particularly when unwinding their Quantitative Easing asset purchases. He pointed out: “Recipient countries are not being irrational when they protest both the initiation of unconventional policy as well as an exit whose pace is driven solely by conditions in the source country.”

If international cooperation is viewed as a bargaining game, what incentives do the advanced economies have for cooperative behavior in light of the asymmetries among nations? Engel points out that in such circumstances, “…the emerging markets may believe that they have too little say in this implicit agreement, which is to say that they may perceives themselves as having too little weight in the bargaining game.” Conversely, central banks in the upper-income countries may in ordinary circumstances see little need to extend the scope of their decision-making outside their borders.

This attitude changes, however, when a crisis occurs, as Frederic Mishkin of Columbia shows in his examination of the response of central bankers to the global financial crisis. The Federal Reserve established swap lines to provide dollars to foreign central banks in countries where domestic banks faced a withdrawal of the funding they had used to acquire dollar-denominated assets. In addition, six central banks—the Federal Reserve, the Bank of Canada, the Bank of England, the European Central Bank, the Sveriges Riksbank and the Swiss National Bank—announced a coordinated reduction of their policy rates. Coordination becomes quite relevant in a world of sudden stops and capital flight.

The need for such activities could increase if there is a global financial cycle, as Hélène Rey of the London Business School has stated. She presents evidence of the impact of global volatility, as measured by VIX, on international asset prices and capital flows. An important determinant of such volatility is monetary policy in the center countries. Rey agrees with Rajan that: “Central bankers of systemically important countries should pay more attention to their collective policy stance and its implications for the rest of the world.”

Perhaps a better motivation for the need for joint action comes from Charles Kindleberger’s list of the responsibilities that a hegemonic power such as Great Britain played in the period before World War I. These included acting as a lender of last resort during a financial crisis; indeed, it was the lack of such an international lender in the 1930s that Kindleberger believed was an important contributory factor to the Great Depression. Since the end of World War II the U.S. has vacillated in this role while the international monetary system has moved from crisis to crisis. Meanwhile, offshore credits denominated in dollars have grown in size, and could conceivably constrain the Federal Reserve’s ability to undertake purely domestic measures.

A policy of “America First” that means “America Only First and Last” ignores the fragility of the international financial system. Just as there are no atheists in foxholes, no one doubts the merits of coordination when there is a disruption of global markets. But suffering another crisis would be an expensive reminder that the best time to minimize systemic risk is before a crisis erupts.